PEG ratio - what does it tell us? - MoneyWeek Investment Tutorials

so in today's video we're going to take a look at the PEG ratio for many investors and improvement on a standard p/e ratio and a great way to work out whether a share is cheap or expensive it's not perfect no single ratio is but we'll be taking a look today why some investors consider it to be stronger than a p/e ratio how you calculate it and also some of the things to bear in mind that might suggest it's not perfect in all circumstances so what is PEG well it stands for p/e to earnings growth ratio so it uses the p/e ratio and takes it one step further now p/e ratios are one way of telling whether a share is cheap or expensive it's the relationship between the current share price and one year's earnings per share now in this video we're not going to spend a lot of time on either of those two concepts I'm asked for one reason there are two other videos in this series which deal with them so for anyone who's not sure about p/e ratios take a look at my video talking all about p/e ratios for anyone not sure about earnings per share have a look at my video on earnings per share and for anyone not sure about earnings at all there is a video called what is profit so going to take for granted that most people watching this video will understand a little bit about earnings per share and a little bit about the p/e ratio okay so what is this thing the PEG well p/e ratios are fine up to a point a basic plain vanilla p/e ratio is a current chair price over the latest earnings per share figure this is normally last year's earnings per share figure although in fairness you can look one year forward and make an estimate but essentially it says you know if the share price is 20 times one year's earnings per share then you're going to wait about 20 years to get your money back if earnings per share doesn't change and such as it is p/e ratios are quite commonly quoted and quite widely used so what's the problem why can't you just say well if I can calculate a p/e ratio of say 20 I can then do some comparisons and work out whether that's cheaper expensive relative to other shares and so on there were problems with p/e ratios how useful is that number number one it's quite difficult to use p/e ratios to compare firms in different sectors different sectors have different p/e ratios utility companies for example typically have fairly low p/e ratios technology companies and telecoms have high p/e ratios so cross sector comparisons can be quite difficult because you'd always expect a telecoms firm to have a higher p/e all other things being equal than a utility company that's a given so really that in itself doesn't tell you much about which one you should buy if either of them so there's one drawback a p/e ratios secondly um p/e ratios really give you a little indication about earnings growth I mean saying I would expect earnings per share to increase if I'm buying a company with a high p/e ratios they all very well but will it and basically p/e ratios are fairly static particularly where earnings per share is taken for the last 12 months really or just looking at the past as a guide to the future so a couple of fairly big criticisms of the ratios there other criticisms this tells you nothing about the size of the profits you'll expect to earn doesn't tell you much about dividends either and also it doesn't really tell you whether this firm can ever turn earnings into hard cash um so for a number of reasons some investors say will be your ratios for an okay starting point though they've got limitations so the PEG goes a step further now the PEG ratio is built on one key it is built on the assumption that the reason you buy a share is because you expect to squeeze future earnings out of it in other words today's share price is simply future earnings lumped together and discounted back for the fact that there's a thing called time value of money so a pound received in 20 years is worth less than a pound now thanks to inflation so essentially a share price represents a string of future earnings if you're not sure about that think about a property in theory a house is only worth the future rental income you can squeeze from it otherwise what's its value um so shares are viewed the same way by fans the PEG ratio and as such the PEG ratio goes a step further than the p/e ratio a peg says actually what we really want to get a handle on is future earnings growth because that really is the reason to buy a share so the PEG ratio is the relationship between the p/e ratio and the firm's earnings growth rate and it gives you a number just like the p/e ratio so you get a number up like one for example okay so how does that work well let's say that I have a firm with a p10 I also know that earnings per share r10 pee now and are expected to be 12p next year as a forecast so just looking at those two years I could say well the earnings growth rate is simply how I get from there to there well that's to pee over 10 P that's 20% so the expected earnings growth rate is 20% and therefore for this company with just two numbers the peg is 10 over that earnings growth rate of 20 and that's not 0.5 so mechanically it's the p/e ratio everybody expected earnings growth rate now in fairness to just look one year ahead is a little unambitious a lot of pegs are calculated by taking an average of the expected earnings growth rate over five years straight away of course you've got a problem which is how do you know what anything is going to be over five years and the answer is you need a forecast okay so if I can crunch out an earnings growth rate and I can get to a PEG ratio of 0.5 so what what does that tell me well fans of the PEG ratio would say that what that reveals is that the share is cheap in other words here's a rough summary of how to use it basically if the PEG ratio is 1 then the share is fairly priced so for example if the P ratio is 10 and the earnings growth rate is 10 percent that mechanically will give you an answer of 1 and that would suggest to peg fans a fair price in other words all shares will tend towards a price to earnings growth ratio of 1 logic the p/e ratio and the earnings growth rate are in kilter and the words of p/e ratio of 10 suggests an earnings growth rate of around 10% okay so but it's not 1 what's my conclusion um if a peg is less than 1 you buy if the peg is above 1 P so very crudely that's the conclusion the PEG fans would draw for our 1/2 strong by more than two strong sell in other words when the peg is less than 1 and just now it was not 0.5 in effect what we're saying is you in theory can pick up future earnings growth for less than it's worth by buying the share so why wouldn't you an equally if the PEG ratio is well over 1 you're paying too much by buying the share of the current price for future earnings growth um so basically by combining the p/e ratio with nurnies growth forecasts we can come up their conclusion about whether the share is cheap or expensive in other words we've got a step further on if you like to just looking at a pure p/e ratio now if investing was that simple I wouldn't be standing here and you wouldn't be sat there so clearly this can't be perfect it cannot be as simple as I screened stocks on this basis and I'm guaranteed to make fortune ah so what are the problems with this thing the PEG ratio and there are two or three let's say number one it's based on earnings forecasts and earnings forecasts prepared by analysts working for banks are notoriously inaccurate so you need to be fairly confident that the earnings growth forecast will enter to the bottom of the formula is in some way meaningful so the first thing to do is to challenge the assumption is it realistic to expect a firm to grow earnings at 25 percent a year for the next five years and usually in the technology sector you get some crazy valuations and when you need to ask some hard questions about whether the earnings growth rate isn't anyway realistic so that's the first problem number two like a p/e ratio this ratio tells you nothing about dividends really it works best on low dividend yield stocks and for anyone not sure about dividend yields take a look at my video on that topic really if you're a dividend investor an actual priority PEG ratios are frankly of limited use the length of that point Peg's tell you nothing about cash flow okay can the firm turn this earnings growth into hard cash and also of course we're making a big assumption that share price investment is driven by future earnings growth that's not true in all all sectors for example in the investment trust sector or the property investment sector book values of assets held on the balance sheet matter more than earnings growth so in those sort of sectors you do something like a price-to-book ratio probably ahead or something like a peg or a P so the ratio needs to flip the sector and finally our PEG ratios like p/e ratios are pretty useless if a firm is lost making but then if a firm is lost making consistently it is pretty useless essentially why would you buy into a firm in any sector that's currently making losses technology sectors investors should take that on board so I would say if a firm's loss making I'm not going to apply any ratio to it because I'm not interested personal just be aware that you try to apply peas and pegs in that situation you'll come unstuck

Channel: MoneyWeek

Views: 142,322

Keywords: stock, market, educational, business, trading, shares, peg, ratio, what, is, how, to, use, investing, investment, tim, bennett, moneyweek, finance, stocks

Id: jfuBbRmksGo

Length: 12min 36sec (756 seconds)

Published: Thu May 12 2011